Greg Mankiw has a long article in National Affairs on the proper way to align incentives and stimulus spending:
Economists will no doubt long debate whether Cash for Clunkers passed a cost-benefit test. (Some early results, from Burton Abrams and George Parsons of the University of Delaware, suggest not.) But the fact that people responded to the incentive as they did — nearly 680,000 cars were purchased — suggests that a broader, more comprehensive program of incentives, such as an investment tax credit, might have stimulated spending even more.
Of course, not all tax cuts or credits are created equal, just as not all direct government spending is. One popular idea in recent years, for instance, has been a tax cut for businesses that make new hires. Indeed, the jobs bill signed by President Obama in March put in place a targeted payroll-tax exemption for some small businesses that hire people who have been unemployed for two months or more; several members of Congress have proposed broader tax cuts for businesses that hire new employees. The premise behind these policies is that, because unemployment is so high even as the economy begins to recover, we should create incentives for businesses to place unemployed workers into jobs.
There is a case to be made for a broad-based payroll-tax cut that might have this effect, but a narrower tax cut for new hires suffers from some major flaws. The basic problem is that we do not know how to properly define — or enforce a definition of — a “new hire.” Presumably we do not want a business to hire Peter by firing Paul and to then call Peter a new hire; this would cause a great deal of inefficient churning in the labor force (not to mention a great deal of unpleasantness for all the Pauls).
In this video from Mercatus’ Capitol Hill Campus, Dr. Bruce Yandle, Dean Emeritus at Clemson University’s College of Business and Behavioral Sciences, points out the faulty premise that stimulus spending increases demand. Instead, he shows that cash for clunkers and the recently expired first-time home-buyer credit simply shifted demand in time.
In short, for an incentive to actually stimulate an increase in demand, it would have to cost significantly more than the benefit created by increased economic activity. Mankiw himself explains that uncertainty is a recurring problem in economic planning:
The negative effects are even more challenging to trace. For example, if people observe the government issuing substantial debt (required to finance a stimulus), they may anticipate higher future taxes and therefore cut back on their current consumption. Increased government borrowing may also drive up long-term interest rates, which could make it difficult for people to borrow money and could therefore reduce spending today. Obviously, recovery.gov has no way to take account of these consequences, either.
Dr. Yandle presents the counter-point that economic uncertainty is not just an unfortunate side-effect of directed planning and incentives. Uncertainty is a prime driver of economic stagnation, both fiscally and psychologically. When economic rules and incentives change rapidly, private investors and business owners have to question their entire rational decision-making process.
Suddenly, planning a business is like building a house on quicksand. The point of stimulus spending is to offset a drop in aggregate demand, and hope that economic growth offsets the cost of the spending.
However, aggregate demand drops, as it did in 2008, because asset values become skewed. Aggregate demand needs time to reset, while consumers and producers determine the appropriate level of supply and demand under new conditions. The market seeks to correct uncertainty. By introducing new rules and incentives, stimulus spending time-shifts this realignment, but doesn’t supplement it. It adds more uncertainty to an already infuriatingly complex puzzle. That’s why such massive spending hasn’t had any noticeable effect on unemployment; it’s probable that Washington, with the best of intentions, has made hiring people more difficult for a longer period of time. It’s the same reason cash-for-clunkers was such a dismal failure, and the home-buyer credit shows the same symptoms.
Far from being a momentary side-effect of stimulus spending, uncertainty is a systemic problem with interventionist economic policy. The poison is worse than the medicine.